Mumbai, Aug. 6: It’s an eerie throwback to 1996-98 — the interregnum when two hotch-potch coalitions at the Centre grappled with the exchange rate shock brought on by the Asian financial crisis. Back then, the Reserve Bank of India had responded by tightening interest rates to stabilise the rupee — a policy strategy that worked very well — and the measures were reversed within two months.

In a span of two months from December 1997 to January 1998, the RBI had raised the bank rate by 200 basis points and increased the CRR by 100 basis points to defend the currency after the Asian financial crisis led to a sharp depreciation in the rupee. There was collateral damage from those measures in that it sparked an economic downturn and led to a rise in bad debt on the banks’ books.

Reacting to the Asian financial crisis, the financial institutional investors responded in the same way as they are doing now by pulling money out of equities, debt securities, and cutting back on loans.

The crisis blew over only after the country issued the Resurgent India Bonds bringing dollars back into the economy that had gone into a downturn with a sharp rise in the bad debts of banks.

The Reserve Bank of India and the government have a similar raft of options before them to tackle the prevailing exchange rate crisis. They can raise policy interest rates, issue sovereign or quasi-sovereign bonds denominated in dollars, hike the interest rate caps on non-resident Indian deposits and adopt measures to bring down the current account deficit (CAD).

The growing belief is that monetary tightening — by raising policy interest rates such as the repo — could drag the economy down, undermine fiscal consolidation efforts and raise the non-performing assets (NPAs) of banks.

But there are a few differences in the situation today from the nineties as well. In 1996-98, the external shock came from the Asian financial crisis, which impacted fund flows into the country. This time, however, there is a fear that the US Federal Reserve could gradually withdraw its quantitative easing programme under which it has been shovelling cheap money into the US financial system, some of which has spilled into emerging markets such as India.

While the current account deficit is a lot worse now, India is a lot better placed today on external debt and short-term debt vulnerabilities.

In a report released today, Edelweiss Securities summed some of the lessons from the past and the possible options that could be adopted.

First, a CRR and repo rate hike cannot be completely ruled out, although the RBI will likely be cautious in using these tools. In the 1997-98 episodes, the central bank had raised both CRR and the bank rate and it did provide some near-term stability to the rupee. However, these measures were reversed two months later.

A sovereign/quasi-sovereign dollar-denominated bond may be issued so as to bring in capital flows. As of now, the RBI remains reluctant to use this tool as it feels that adding to external debt may increase India’s vulnerability at this stage. In the previous episode, when India witnessed capital outflows post the nuclear blasts in 1998, the authorities issued Resurgent India Bonds (RIBs) in September 1998 (a 5-year bond at an interest rate of 7.75 per cent) with risk borne by the State Bank of India (it was a quasi-sovereign bond). The move was fairly successful as it attracted $4 billion, which helped stabilise the rupee.

There is a strong possibility that the interest cap on NRI deposits could be raised. The RBI had used this tool in late 2011 when the rupee was under pressure.

Finally, the government has already undertaken measures such as interest rate subvention for exporters to support exports. Similarly attempts have been made to reduce gold imports as well through several measures. Going ahead, there might be duty hikes in imports of various non-essential commodities so as to narrow the trade gap.

But the report adds that these measures “can bring respite in the short-term only”.

“We think that in the current depressed growth scenario, attracting flows through bond issuance is better suited compared to monetary tightening. Keeping liquidity tight for too long could prove counter-productive by deepening the economic slowdown, hurting fiscal consolidation and raising NPAs for banks — all of which can lead to ratings downgrade,” the Edelweiss report added.